Dear Gail-

Some time ago you wrote about the tax that minors have to pay when their income is higher than a certain amount. My son starts college this fall and I was wondering, if we managed to keep his income below this amount, could he sell some stock we’ve set aside for his education and avoid income tax on it?

Thanks,
Gerald

Dear Gerald,

I think I see where you’re going with this, but for the sake of others, allow me to explain. There are two different elements of the tax code involved.

A Capital Idea

The first piece is what’s happening with the capital gains tax.

As you may recall, back in 2003, in order to help revive the economy in the wake of 9/11, Congress decided to reduce the tax paid on long-term capital gains, i.e. the tax on the profit made when you sell an investment that you have owned for at least a year.

The top rate fell from 20 percent to 15 percent. Those in the two lowest income tax brackets would only pay 5 percent. In 2008, this 5 percent rate would drop to 0 percent.

That’s right. For one year only — 2008 — individuals in the 10 or 15 percent tax brackets would not have to pay any tax on the profits they earned from selling long-term investments.

Starting in 2009, long-term capital gains rates would revert to their previous levels.

However, thanks to the Tax Increase Prevention and Reconciliation Act passed last year, the 0 and 15 percent capital gains tax rates were extended through 2010.

A Shifty Move

At first this would seem to create a golden opportunity for parents in higher tax brackets to transfer assets to their children so the kids could sell them — a strategy called “income-shifting.”

Here’s how it works: Mom and Dad “gift” the appreciated stock/bond/mutual fund/etc. to Junior. Once he’s the owner, Junior sells the property. Because he probably has little or no income, he either pays 5 percent on the gain or, if he waits until 2008 to sell, the profits could conceivably be tax-free.

However, this isn’t as easy as you might think, thanks to another part of the tax code commonly referred to as the “kiddie tax.” In a nutshell, if a child’s income exceeds a certain amount, then he is taxed based on Mom and Dad’s income instead of his own.

Not Exactly Child’s Play

Under the “kiddie tax,” children only have to pay federal tax on income that exceeds $850/year. Another way to look at this is that the first $850 a child earns, say, from a paper route or from baby-sitting, is tax-free.

Income between $850 and $1,700* is taxed at the child’s tax rate. Unless your kid is a child actor, at most this is typically in the neighborhood of 10 percent on earned income and 5 percent on long-term capital gains.

The catch is that if the child’s income is more than $1,700, the excess is taxed at the highest rate his or her parents are subject to.

In the case of long-term capital gains, instead of paying a tax of 5 percent (or next year, 0 percent), the child might have to pay 15 percent — the same as his or her parents. This wipes out the tax benefit and thus discourages Mom and Dad from attempting to reduce their tax bill by transferring property to their children.

Re-Defining "Child"

Up until last year, the “kiddie tax” applied until a child reached age 14. After that, the child would be considered separately from Mom and Dad and in most cases would qualify for the lowest tax rates. Predictably, parents would transfer assets to the child and have him or her wait until age 14 to sell them.

This strategy is no longer feasible.

TIPRA not only extended the lower rates on capital gains, it also raised the age on the “kiddie tax” to 18. As a result, parents who want to give a child significant assets to sell at lower tax rates now have to wait four more years.

None-the-less, it’s still worthwhile: if the profit exceeds $1,700, the child would probably pay 5 percent in capital gains tax as opposed to the 15 percent Mom and Dad would generally pay.

Moreover, if the assets were sold by the child in 2008-2010 there would probably not be any tax on capital gains, especially if he or she was in college and didn’t have a large income.

As you can imagine, parents have been salivating over this prospect.

Smarter Than We Like to Think

While surely no one would argue that Congress is made up of geniuses, its members aren’t exactly stupid. It didn’t take long for them to recognize they’d created a tantalizing tax loophole.

So, this spring they tweaked the tax code again: starting January 1st, 2008, the "kiddie tax" will apply until:

a) the year the child reaches age 19, or
b) if the child is attending school full-time and is listed as a “dependent” on the parent’s tax return, until the year she/he reaches age 24.

In other words, if your child is in college, giving her long-term capital gain assets to sell probably won’t enable her to avoid the “kiddie tax.”

Window of Opportunity

All is not lost, however, if you act quickly.

Since the higher age for the “kiddie tax” doesn’t kick in until next year, between now and then it’s still possible to exploit the loophole by gifting assets to someone who is at least age 18. In fact, they don’t need to be 18 years old on the day they sell the property — they just have to turn 18 some time this year!

At the very least, they would probably qualify for the 5 percent capital gains rate currently in effect. As a result, their tax bill would be two-thirds less than what Mom and Dad would probably have to pay if they sold the asset.

Uh-Oh for UGMAs & UTMAs

The new “kiddie tax” rules make “Uniform Gift to Minor” and “Uniform Transfer to Minor” accounts much less attractive. These accounts enable an adult to save money or make investments in the name of a minor, often for the purpose of paying for college at some future date.

The problem is, the child has to pay tax on the earnings in an UGMA/UTMA every year. Thanks to the fact that the “kiddie tax” rules now apply until much higher ages, there’s a good chance the child will be paying at Mom and Dad’s rate instead of his own.

For instance, assume that Junior, a freshman at State U., has a UGMA that is entirely invested in bonds and CDs that generate $3,000 a year in interest. Mom and Dad are in the top ordinary income tax bracket — 35 percent.

During the summer Junior works as a life guard at a community pool. The rest of the year he’s a full-time student. His parents claim him as a dependent on their tax return since they provide more than half his support.

Even though he’s considered an “adult” under state law, starting next year, Junior will be subject to the “kiddie tax” rules. (The tax code doesn’t care that he is 18-years-old and eligible to vote!) The $3,000 that Junior’s UGMA earns in 2008 will be taxed as follows:

$850 - no tax
$850 - taxed at 10 percent (Junior’s tax bracket)
$1300 - taxed at 35 percent (parents’ tax bracket)

In contrast, 529 plans are not subject to the "kiddie tax" rules. That’s because gains and income in these accounts are not taxed annually; instead, they are tax-deferred until the money is withdrawn. And, provided 529 withdrawals are used to pay qualified college expenses, they are completely tax-free.

Hope this helps,
Gail

*These dollar amounts are periodically adjusted for inflation.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.